Founded by Former SEC Attorneys

Guest Columnist Robert Heim is a partner at Meyers & Heim and was formerly the assistant regional director of the SEC’s New York Office. Co-writing this column is Magdalena Kadziolka, an associate at the firm.

      Through the $45 million Value Line settlement, the SEC has sent a strong message to mutual funds, their investment advisers and boards: that commission rebates are the property of the mutual funds. Therefore, investment advisers and their broker-dealers must be extremely vigilant in carrying out their duty of best execution. Board members should become familiar with the Value Line decision. They then should formulate their own responsive actions by taking steps to ensure that their funds do not have similar compliance issues.

      The Value Line settlement also highlights the importance of using outside auditors to assist in reviewing commission agreements, and the need to review SEC public filings to confirm that these documents accurately disclose a fund’s commission arrangement. Clearly, whenever a fund board is blindsided by alleged fraudulent actions that occurred underneath its watch, we all as an industry need to make an effort to prevent history from repeating itself.

      In the Value Line case, the SEC alleged that from 1986 to November 2004 the adviser to the Value Line funds, the broker-dealer, Value Line CEO Jean Buttner and chief compliance officer David Henigson arranged to forward fund trades to three unaffiliated brokers at discounted commission rates. The SEC says the funds did not receive the benefit of the discounted commissions. Instead, the Value Line broker-dealer retained the commission rebates even though it did not provide any brokerage services to the funds for the trades in question.

      The SEC further alleged that in order to guarantee a quarterly profit for the broker-dealers, Buttner, with Henigson’s knowledge, required that a certain percentage of the funds’ trades be allocated to the unaffiliated brokers as part of a commission recapture program. This practice resulted in the selection of brokers based not on best execution for the funds’ trades, but on management’s targeted profits for the broker.

      The SEC also alleged that Buttner and Henigson made misleading disclosures to the funds’ independent directors regarding the commission recapture and the broker-dealer’s role. Similar misleading statements were made to the funds’ shareholders through public disclosures and SEC filings, including mischaracterizing the services provided to the funds and the broker-dealer.

      The SEC settlement requires the adviser and the broker-dealer to pay almost $25 million in disgorgement, $9.5 million in pre-judgment interest and a $10 million civil penalty, and imposes a cease-and-desist order. Among other things, the SEC imposed a $1 million civil penalty on Buttner and a $100,000 civil penalty on Henigson. It also barred each of them from association with any broker, dealer, investment adviser or investment company and from serving as officers or directors of any public company.

      In particular, directors should consider taking the following steps:

• Board members should consider reviewing the actual agreements their funds and advisers have in place with broker-dealers to ensure that such agreements fulfill the brokerage’s obligation to provide best execution services. This board-level review can be conducted with personnel from the adviser’s best execution committee with a focus on commission rates, best execution and commission recapture programs.
• Bring in an outside adviser or auditor to assist in the review of commission arrangements if board members are unfamiliar with the complexities of such arrangements. Specifically, board members should understand the services performed by each broker-dealer (execution, settlement, clearing, etc.) and the commission rates charged by the brokerage for these services.
• Review the adviser’s Form ADV and the fund’s public filings with the SEC to confirm that these documents accurately disclose the fund’s commission arrangements.
• Good corporate governance dictates that the board document all of their actions with meeting minutes and board resolutions. Good documentation of board actions will help establish that board members fulfilled their duty of care to the fund. Board members should also devote adequate time to the review of the fund’s commission arrangements. Discussions concerning these issues will likely occur over the course of several board meetings.

      Remember that the failure of a mutual fund’s adviser and affiliated broker-dealer to treat commission rebates as fund assets can lead to significant sanctions by the SEC. Board members who make efforts to understand commission arrangements and recapture programs will be more likely to avoid the costly deceptions that led to the Value Line settlement.

      In the end, all fund family stakeholders will benefit from this extra vigilance.

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